Here's Why CECEP Solar EnergyLtd (SZSE:000591) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that CECEP Solar Energy Co.,Ltd. (SZSE:000591) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for CECEP Solar EnergyLtd

What Is CECEP Solar EnergyLtd's Debt?

As you can see below, CECEP Solar EnergyLtd had CN¥18.4b of debt at September 2023, down from CN¥20.1b a year prior. However, it does have CN¥3.76b in cash offsetting this, leading to net debt of about CN¥14.7b.

How Healthy Is CECEP Solar EnergyLtd's Balance Sheet?

The latest balance sheet data shows that CECEP Solar EnergyLtd had liabilities of CN¥7.16b due within a year, and liabilities of CN¥16.9b falling due after that. Offsetting these obligations, it had cash of CN¥3.76b as well as receivables valued at CN¥11.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.59b.

While this might seem like a lot, it is not so bad since CECEP Solar EnergyLtd has a market capitalization of CN¥21.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CECEP Solar EnergyLtd has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. CECEP Solar EnergyLtd grew its EBIT by 9.1% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since CECEP Solar EnergyLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CECEP Solar EnergyLtd produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen CECEP Solar EnergyLtd is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. In particular, we thought its EBIT growth rate was a positive. Looking at all this data makes us feel a little cautious about CECEP Solar EnergyLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that CECEP Solar EnergyLtd is showing 2 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.